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Few Discounts in Real Estate

Areas hurt most by the pandemic have rebounded.

The Morningstar US Real Estate Index is up 32.4% over the trailing 12 months, which is slightly below the 35.9% of the broader U.S. equity market over the same period. However, the real estate index trailed for much of the past 12 months and only caught up with the broader index as the rapid rollout of coronavirus vaccinations across the U.S. gave investors confidence in real estate fundamentals.

Real Estate Has Recently Pulled In Line With the U.S. Equity Index

Source: Morningstar

The real estate sector is currently trading relatively in line with our fair value estimates. Our real estate coverage currently trades at a 2% discount to our estimate of fair value, which is in line with our total coverage trading at a 1% premium to our fair value estimates on average at the end of the second quarter. Currently, 45% of the real estate sector is trading in 3-star range, while only 15% of our real estate coverage is trading in 4-star range and 15% is trading in 5-star range.

Few Discounts Among Real Estate Companies

Source: Morningstar

The real estate index outperformed the broader U.S. equity index in the second quarter and so far in the third quarter. After the rapid deployment of vaccines across the U.S. early in 2021, fundamentals for many real estate sectors recovered faster than anticipated, leading to many REITs improving 2021 guidance on their first-quarter earnings calls in early May. Many sectors saw continued occupancy and tenant health improvements through the summer months, leading to further guidance raises for many companies on the second-quarter earnings call in late July and early August.

Hard-Hit Subsectors Have Outperformed Since the Vaccine Announcement

Source: Morningstar

The hotel and retail subsectors were hurt the most by the pandemic, and they have both massively outperformed the broader real estate market since the announcement of a vaccine (Exhibit 11d). The vaccine allows travelers to return to hotels and shoppers to return to stores, significantly reducing the risk of bankruptcy for these companies and making the path to recovery clearer. While the delta variant led to the hotel subsector trading off during the summer months as uncertainty rose, September saw a rally in share prices as occupancy and rate growth has remained strong despite higher coronavirus cases. We continue to believe that hotels and malls will see years of strong growth ahead of them. We currently see some value picks for investors among these hardest-hit subsectors, though the recent rally has significantly reduced the discounts for these names.

Top Picks

Simon Property Group SPG Star Rating: ★★★ Economic Moat Rating: None Fair Value Estimate: $149 Fair Value Uncertainty: High

Class A malls continue to outperform other forms of brick-and-mortar retail. The stock sold off significantly during the height of the pandemic as fears of the coronavirus impact on brick-and-mortar retail sales grew among investors. Simon has long-term leases with tenants, so it continued to receive rent even during the worst months of the crisis. However, brick-and-mortar sales quickly rebounded as people returned to stores and Simon has been able to improve occupancy in 2021. Additionally, Simon recently acquired Class A mall competitor Taubman Centers, which should increase cash flows and provide more leverage when negotiating with tenants.

Pebblebrook Hotel Trust PEB Star Rating: ★★★ Economic Moat Rating: None Fair Value Estimate: $27.50 Fair Value Uncertainty: Very High

While the coronavirus significantly affected Pebblebrook's operating results, with high-double-digit declines in revenue per available room and negative hotel EBITDA in 2020, the company has seen a significant rebound in 2021. Leisure travel has rebounded to near prepandemic levels, leading to a return of positive hotel EBITDA. However, business and group travel has been slower to recover as office workers have yet to fully return to the office. Still, we think business and group demand will eventually return to prepandemic levels by 2025, leading to years of strong growth for Pebblebrook.

Ventas VTR Star Rating: ★★★★ Economic Moat Rating: None Fair Value Estimate: $64 Fair Value Uncertainty: Medium

Ventas owns high-quality assets in the senior housing, medical office, and life science fields. While the company's medical office and life science portfolios should be relatively unaffected by the coronavirus outbreak, the senior housing portfolio has experienced a very significant impact to occupancies, as the virus has the highest lethality rate among senior citizens. However, while virus will continue to negatively affect net operating income through 2021, the industry should see strong long-term growth from the coming demographic wave of baby boomers aging into senior housing facilities.

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